Hedging in Times of Production Uncertainty

With the recent concern in the swine industry about Porcine Epidemic Diarrhea Virus (PEDV) and record high futures prices for lean hogs at the Chicago Mercantile Exchange (CME), discussions have occurred about how farmers can take advantage of high prices while protecting themselves in case hogs are not be available to market. This issue is not unique to the swine industry; crop producers face the same type of scenario in a drought year. While revenue based crop insurance provides some protection in the case of crop production, livestock producers don't have the luxury of a product exactly like the crop insurance products. There are however, exchange based tools that can be used to provide price risk management without obligating delivery of live hogs as a packers' forward contract would require.

If a hog producer is interested in locking in a future price on a portion of his production he would traditionally either sell a futures contract near the anticipated deliver month or enter into a forward cash contract with a packer. In the current environment, with the risk of disease causing abnormally high mortality for a period of weeks, the producer may not be able to deliver hogs to the packer under the forward contract which in most cases is delivery obligated. Growers need to be aware of the non-delivery penalties that are written into the contract if spelled out. In some cases, the grower would be responsible for acquiring enough hogs from another source and delivering them against his contract, regardless of what has happened to the price since the contract was written. If supplies continue to be tight due to the production problems associated with disease, and the price has increased, a significant market loss would take place.

In the case where the producers used a CME futures contract to manage price risk, delivery is not obligated. Under normal circumstances the grower would sell (or go short) a futures contract and hold that contract until delivery into normal marketing channels were to take place and a cash price for the hogs was offered. At that time, the futures contract would be bought back. If the price had dropped, the grower would realize a gain in the futures market which would be added to the cash price to the marketed hogs. If the price had gone up, the grower would realize a loss in the futures market, but would have realized a higher price in the cash market which would offset the loss in the futures contract. If the hogs were not able to be delivered due to a disease outbreak, the grower could buy back the futures contract and realize a gain if the futures price for lean hogs had dropped. If, however, the futures price had increased, a potentially large loss on the futures contract would result with no offsetting gain from sales of lean hogs.

The potential for large market losses in addition to the already potentially devastating disease losses associated with a PEDV outbreak might cause many hog producers to decide not to hedge future production at record or near record futures prices for lean hogs. There is a strategy that growers can use to manage price risk with limits on the potential market price loss in the event of continued increasing prices if delivery were unable to occur. The grower could purchase put options, which are contracts that give the buyer the right, but not the obligation to sell lean hog futures at the selected strike price. The grower then has the right to sell hogs at the strike price or can allow the put option contract to expire if the price has gone up. This strategy doesn't come without a cost however. Recently July 2014 CME lean hog futures traded at $124.00 per hundred weight. An at the money put option (strike price $124.00) had a premium cost of $5.10 per hundred weight, resulting in an equivalent futures price of $118.90 per hundred weight. This is relatively expensive and may not appeal to many producers. There is another strategy that may work better for hog growers, that is to buy put options as a floor on price and holding them until the pigs have reached a stage of growth where a disease outbreak would not impact them as it would when they were younger. At this point the put options could be bought back, hopefully with a minimal loss, and a futures contract could be sold to hedge the price of the hogs to be marketed later. A packer forward cash contract could also be entered into at this time and the futures contract would be unnecessary.

In times of production uncertainty, farmers and ranchers shouldn't ignore price risk management when we have tools that allow them to manage price risk without obligating delivery in case of production losses.